Why Is Citigroup Stock So Cheap? (NYSE:C)

Citigroup (NYSE:C) is currently trading at a depressed valuation that doesn’t seem to be justified, providing a good entry point for long-term investors.

Background

With rising interest rates in the U.S. and across major economies in the world over the past few months, one of the U.S. banks that, theoretically, should benefit most from this environment is Citigroup. This is because the bank is one of the few remaining global banks, providing a wide range of financial products and services throughout the globe.

While the bank has streamlined its global presence since the global financial crisis and continues to restructure its profile, namely through divestments of non-core assets and the simplification of its organization, it still has a unique global footprint across large U.S. banks, with much more exposure to international markets than its two closest peers, JPMorgan (JPM) and Bank of America (BAC).

Therefore, beyond higher rates in the U.S. that boost its net interest income (NII) and income from its securities portfolio, the bank also benefits from rate hikes in other geographies, particularly in countries where it has significant retail operations.

Despite this profile and the strong tailwinds from higher interest rates, its share price is down by about 20% over the past year, and its stock (white line in the following graph) has been weaker than JPMorgan, and close to Wells Fargo (WFC) and Bank of America.

Moreover, its current valuation is quite distressed, considering that Citigroup is currently trading at only 0.5x book value, at a considerable discount to its own historical average and its peer group (trading close to book value). As shown in the next graph, Citigroup is currently trading close to its bottom valuation over the past five years, and at about a 30% discount to its historical valuation of about 0.8x book value over the past five years.

This can either mean that Citigroup is currently undervalued or that its business has some fundamental issues, and its cheap valuation can be a value trap. For investors, it is critical to analyze the bank’s fundamentals to understand if the bank’s current depressed valuation is an opportunity, or the result of fundamental issues that aren’t easy to change.

Fundamentals

To understand if this valuation is warranted or not, there are several factors that should be taken into account, including financial performance, growth, credit quality, capitalization, and prospects of capital returns, among others.

Looking at the bank’s historical financial performance, its track record is not particularly impressive considering that revenue has been relatively flat over the past five years between $72-75.5 billion per year, and net interest margin has declined from 2.80% in 2017 to 1.99% in 2021.

However, as interest rates have increased over the past few quarters, revenue in 2022 recovered to $75.3 billion, supported by higher NII that reached $48.6 billion in the year (+15% YoY). Nevertheless, revenue growth is quite low and, according to analysts’ estimates, it should not grow much beyond $77 billion over the next couple of years. This means that Citigroup’s top-line growth is weak, which is a negative factor for its valuation.

Regarding its expenses, while Citigroup has divested several units and performed some cost-cutting initiatives in recent years, its annual cost base has been between $43-44 billion over the past few years, while it increased to more than $48 billion in 2021. During the past year, its annual expenses increased to $51.3 billion, up by 6% YoY due to several structural and restructuring impacts. This led to an efficiency ratio of 68% in 2022, above its average over the past six years, which is not among the most efficient levels in the industry, thus rising expenses and lower efficiency (a higher ratio is bad) are also another negative factor for its valuation.

However, other banks that have depressed valuations, such as Credit Suisse (CS) or Deutsche Bank (DB), have worse efficiency ratios (110% and 72% in Q3 2022, respectively), thus I don’t see Citigroup’s efficiency level has a major issue to justify its depressed valuation.

On credit quality, Citigroup has much higher exposure to international markets than its closest U.S. peers, which leads to a higher risk profile and credit losses throughout the economic cycle. Furthermore, the bank has also one of the highest exposures among large U.S. banks to credit cards, which is one of the riskiest loan segments. Both of these factors are a major reason why the bank has historically traded at a discount to its closest peers in my view.

Considering that global economic conditions have deteriorated in recent quarters and the prospects of an economic recession in the U.S. and elsewhere in the coming quarters are substantial, this means Citigroup’s credit quality is expected to worsen more than compared to its competitors. This trend was already visible in the last few quarters, considering that credit costs amounted to $5.2 billion in 2022, of which more than $1.8 billion were booked in Q4 (+35% QoQ).

Therefore, higher credit costs are also a negative factor for the bank’s valuation, and the issue here is how much in losses the bank will book in 2023, as loan defaults are usually a lag indicator and take some time to materialize compared to when the economy starts to weaken (usually it has a time lag of between six and nine months). Moreover, the bank also has some $7.5 billion exposure to Russia, which can also be problematic in the near future and lead to some credit losses.

Its provisions for loan loss ratio was 80 basis points (bps) in 2022, while before the pandemic its ratio has been usually between 100-120 bps. Thus, it is likely that credit costs will have a negative impact on Citigroup’s bottom line in 2023, even though a ‘normal’ level of provisions is likely to be about $7-8 billion for the full year, thus the impact should be relatively manageable.

Regarding profitability, its return on tangible capital ratio was, on average, about 10% over the past five years, which is a below-average profitability level and also a key factor why Citigroup usually trades at a lower multiple compared to its closest peers. In 2021, as the bank’s net income decreased by 32% YoY to $14.8 billion, its RoTCE was down to 8.9%. In Q4, due to higher provisions, its RoTCE was even lower at 5.8%.

The bank acknowledges that it has a profitability issue and wants to improve its returns in the coming years, by divesting several retail and consumer units in Asia, plus the sale of some segments in Mexico, aiming to improve its RoTCE to about 11-12% over the next three to five years. While if the bank executes well and delivers its target it will be an improvement compared to its history, it will still report a lower profitability levels than its closest peers (average RoTCE of 13% between 2017-21), thus Citigroup should be more ambitious on its divestments and focus its operations on segments where it can achieve higher profitability.

Regarding its capitalization, its CET1 capital ratio was 13% at the end of 2022, and its leverage ratio was 5.8%, which is a good level of capitalization and I don’t see this factor being negative for its valuation. While due to a higher risk profile a higher capitalization could be warranted compared to peers, this is reflected in its current capital requirement of 12%, which means that Citigroup has some 100 basis points of capital buffer. Thus, I see Citigroup as being adequately capitalized, and this factor doesn’t seem to be an issue to justify a depressed valuation.

On capital returns, Citigroup has historically returned excess capital through dividends and share buybacks, even though it has suspended more recently share buybacks to increase organically its capital position, due to higher capital requirements in recent quarters (it increased from 11.5% to 12% recently). While JPMorgan and Wells Fargo will resume share buybacks this quarter, Citigroup took a more conservative position and decided to wait for the closing of the disposal of its Mexican unit to decide on resuming share buybacks, which is likely to happen during 2023.

On dividends, Citigroup has delivered a stable quarterly dividend of $0.51 per share since 2019, which at its current share price leads to a dividend yield of more than 4%. This yield and the prospects of share buybacks are positive for its valuation and could be even a catalyst for a higher multiple in the coming months.

Conclusion

While Citigroup is not a quality bank, has a higher risk profile than its peers, plus its historical financial performance and profitability aren’t impressive, which are all factors that justify a discounted valuation, its current depressed price-to-book value multiple seems to be too harsh.

The bank is taking some steps to improve its profile and the cyclical backdrop doesn’t seem to be bad enough to justify a depressed valuation, thus Citigroup seems to offer value at its current share price for long-term investors as the bank’s valuation is likely to return to its historical multiple when investor sentiment improves relate to the bank.